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Five Years After the Crisis, Can We Prevent the Next One?

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The United States has made progress toward avoiding a new financial crisis, but has more yet to do to avert future financial instability, a Federal Reserve governor says.

In a little-noted speech given earlier this month at the Peterson Institute for International Economics, Daniel Tarullo, a specialist on banks and regulation, offered some encouraging words about progress made in the five years since the collapse of Bear Stearns destabilized the U.S. financial system.

That crisis began with the exposure of the risks of a shadow banking system, whose poorly regulated derivative products were previously seen to benefit the economy (by lowering financing costs, for example).

“When, in 2007, questions arose about the quality of some of the assets on which the shadow banking system was based—notably, those tied to poorly underwritten subprime mortgages—a classic adverse feedback loop ensued,” he said, adding that investors became unwilling to lend across a broad range of assets.

Compounding the problem, this credit freeze affected financial firms the government deemed too big to fail, thus triggering the bailout of firms such as Bear Stearns and AIG.

Fast-forward to today, and Tarullo, a former Clinton administration economic advisor, says that the largest institutions enjoy much greater protection against such episodes, mainly as a result of a doubling of capital reserves that decrease large institutions’ leverage.

The largest 18 banks, which represent more than 70% of total assets of U.S. bank holding companies, have seen their Tier 1 capital (shareholder equity that can absorb capital losses) rise from “5.6% at the end of 2008 to 11.3% in the fourth quarter of 2012, reflecting an increase in Tier 1 common equity from $393 billion to $792 billion during the same period.”

While U.S. financial institutions are now more capable of absorbing capital losses, they remain very vulnerable to another credit freeze, a too familiar dynamic Tarullo describes as “exogenous shocks to asset values leading to an adverse feedback loop of mark-to-market losses, margin calls and fire sales.”

That risk will not go away until there is some comprehensive regulation of repo, reverse repo, securities lending and borrowing, and securities margin lending—which Tarrulo sees as unaddressed structural weaknesses of the “wholesale funding” market. U.S. regulators have only taken discrete steps in this direction, such as efforts to regulate money-market funds, he says.

As for ending too-big-to-fail, Tarullo makes a number of proposals, one of which is to require large financial institutions to have “minimum amounts of long-term unsecured debt that can be converted to equity and thereby be available to absorb losses in the event of insolvency.” The idea, in other words, is to supplement banks’ higher capital reserves so that any losses are borne by the firms alone.

The Federal Reserve governor concludes by urging completion of Dodd-Frank and Basel III rulemaking, but adds “we would do the American public a fundamental disservice were we to declare victory without tackling the structural weaknesses of short-term wholesale funding markets.”